BRAZIL MEMO: THE RETURN OF INFLATION

CARLOS GERALDO LANGONI

November 2nd, 2020

• Europe’s new pandemic wave has raised global risk aversion. Risk assets in Brazil have been negatively impacted. The São Paulo Stock Exchange index has shown great volatility.

• A wide gap between the consumer price index and the general price index reflects increased demand for commodities, which is amplified by the exchange overshooting. How long this gap will last is an open-ended question. The Central Bank’s Focus bulletin holds the view that price indexes will converge.

• The political impasse about the reforms agenda brings into question the efficiency of Central Bank’s current monetary easing policy.

The new wave of the pandemic in Europe and the United States has raised global risk aversion.

Therefore, the Real devaluation bias has been reinforced, with the dollar once again approaching the emblematic level of 6 Reais.

Scenarios:

Despite strong corporate balance sheets, particularly in the banking sector, the increasing volatility of the São Paulo Stock Exchange index is negatively impacting risk assets.

Inflation is the new challenge. The gap between the consumer price index (IPCA) and the general price index (IGP-M) is noteworthy.

2020 is expected to end with consumer prices in the range of 3%, while the general index is expected to reach above 20%. In October alone, the IGP-M increased by 3.23%.

The above unusual gap reflects increasing demand for commodities amplified by foreign exchange overshooting.

The difference between marketable and non-marketable products is at the root of inflation discomfort. The duration of the gap is an open question: with the recovery of domestic activity, the price of services will tend towards a moderate increase.

It is also reasonable to expect a more significant increase in public tariffs that was postponed due to the covid-19.

The extent of the commodity cycle, which crucially hinges on China's new growth stage, remains to be seen.

Monetary Policy Committee:

The maintenance of the base rate at 2% suggests that the Central Bank is still betting on a benign scenario, where inflation expectations will not be contaminated either by the exchange overshooting or the increasing demand for commodities.

The Central Bank also took into account the fragility of the labor market: despite the continuous improvement in the creation of formal jobs (330 thousand in September), informality remained high, reaching 38% of the employed population in Q2 according to the Continuous National Household Sample Survey. On the other hand, the unemployment rate maintained a strong upward trend at 14.4%.

The Central Bank Focus bulletin holds the optimistic view that price indices will converge and that prices will only increase moderately in the coming years, within the official cap of 3.75% in 2021.

Thus, there would be room for maneuver to maintain the monetary easing policy - a key instrument for the quickest exit from the recession dip.

The Getulio Vargas Foundation Industrial Survey points to a moderate resumption. On the other hand, there was a decline in confidence in the services sector in October, reflecting increased uncertainty.

To enable this still comfortable inflationary scenario it will be necessary to set about dealing with the imbalances in public accounts, marked by the public debt-to-GDP ratio’s explosive trend.

In this sense, the political impasse in relation to the progress of the reform agenda and its approval in Congress fuels the wave of uncertainties and can put in check the current strategy of the Central Bank.

The weakening of the fiscal anchor would have an immediate impact on the exchange rate, negatively affecting inflationary expectations.

Therefore, the strategy of gradually adjusting the base rate would be compromised. Monetary tightening could interrupt or even make the resumption unfeasible.

In other words, the threat of accelerating inflation forces the Government to redouble its commitment to the rapid reconstruction of the fiscal architecture. Any failure will have a high economic, social and political cost.

In a nutshell, the 2nd wave of the pandemic in Europe and in the United States has raised the level of global uncertainty, despite signs of an asymmetrical recovery in the world economy.

In the case of Brazil, domestic tensions that threaten governance were amplified by renewed inflationary pressures.

Inflation calls into question the continuity of the Central Bank’s monetary easing policy, further enhancing fiscal adjustment as a priority.